Originally published November 26, 2019
Ask any private wealth manager what the safest investment to make is and they will invariably say an investment in a long-term US Treasury bond. Thought of as the “gold standard” of reliable investments, US Treasury bonds are a crucial part of most balanced portfolios as the dominant section of the securities category. Recently, both domestically and internationally, a new type of such government bonds is being discussed in legislatures and national banks: The Green Bond. A Green Bond is, generally speaking, equivalent to a normal bond issued by a large organization except for one key difference: the funds generated from selling Green Bonds are specifically earmarked for climate change and environmental projects. Green Bonds have been emerging as a trend in financial markets everywhere, with Bloomberg New Energy Finance analyst, Daniel Shurey, predicting that, in 2019, anywhere between $170 billion and $180 billion of Green Bonds would be sold. Even then, they make up a small fraction of the $100 trillion bond market.
The growing interest in Green Bonds is representative of an aggregate increase in impact-based investing, or investments with intended social and environmental benefits. These securities are a unique form of ESG (Environmental, Social, and Corporate Governance) investing and face many of the same issues and benefits as the larger impact investing market. These include struggling with defining objective metrics to value the impact achieved and incentivizing investors to divert their capital into more sustainable businesses and projects. Often cited as a key step forward in responsible investing, Green Bonds are important for any aspiring impact investor to understand.
To unpack the advantages and disadvantages of Green Bonds and to determine their validity as socially conscious investments, we must first understand how bonds really work. Essentially, bonds are a form of a loan from a private investor to a company or government. The issuer of the bond, usually the government or a corporation, asks groups of private investors for certain amounts of money. If the investors believe in the stability of a company and its ability to pay back its debts, they will loan the issuer the amount that they are asking for. In other words, this would be the investor purchasing the bond. These bonds have a set maturation date, which is the date at which the issuer will return the principal amount to the investors. At the time of purchase, the bonds will also have a set coupon rate, which is the interest that the bond pays to the investors. Bonds that are more unstable, less likely to reach maturation, and are paid back in a longer timeframe tend to be riskier investments, and are thus often compensated with high interest rates and high potential returns. Contrastingly, bonds from more financially predictable actors that reach maturation quicker tend to have lower interest rates because of their high probability of returns.
The key difference between bonds and other forms of traditional investments, such as stocks or derivatives, is that bonds do not actually grant the owner any ownership stake in a company or government. As a result, bonds tend to be more stable forms of investment, both for the loaner and the loanee, because the value of the money loaned does not fluctuate with the market or the success of the business. For the two parties that are involved in the initial financing of a bond, the values of the bond and interest do not change. Instead, a secondary bond market responds to changes within industries and businesses. If investors are not able to buy bonds during their primary financing with the face-value price, they can buy any bonds being sold through this secondary market. Within the secondary market, the sellers of the bonds can set prices and premiums based on a bond’s volatility and maturation date. This allows for financial interactions with bonds even after they are first released to investors.
With generic corporate and municipal bonds, the money raised can be distributed at the company or government’s discretion. This is where Green Bonds stray from the pack. Rather than just being loans for companies, money generated from Green Bonds are “required” to be used for environmentally friendly projects. These may include focusing on energy efficiency, pollution prevention, sustainable agriculture, fishery and forestry, the protection of aquatic and terrestrial ecosystems, clean transportation, sustainable water management, and the development of environmentally friendly technologies. For example, the Energy Security and Efficiency Enhancement Project in Jamaica raised 14.5 million USD through such bonds to create three wind farms, two solar farms, and a hydro plant. In spite of successes like Jamaica’s, one of the most common criticisms regarding Green Bonds is the wide variety of projects that can be financed.
Many critics claim that the wide scope of what constitutes a “green” bond allows the organizations that issue them to utilize the capital raised for projects promoting sustainability that, in reality, have minimal climate impact. For example, the operator of China’s Three Gorges Dam issued $840 million in Green Bonds to be used for backing wind power projects in Europe. At a surface level, these bonds seem like a sustainable way to raise money and divert it to climate conscious projects. Looking deeper however, the Three Gorges Dam has been continuously cited as a source of water pollution and as damaging for the surrounding ecosystems. Regardless, investors rushed to buy bonds at face-value and overlooked the possible deeper environmental harms they may cause. This process, known as “green washing,” has become a common practice among green bond issuers and is hurting the credibility of such investments. Another instance of greenwashing took place when the Chinese government issued Green Bonds to finance coal-efficiency projects that find ways to burn fossil fuels more effectively. Similarly, a Madrid-based oil and gas company named Repsol issued a set of “Green Bonds” that were used for making their oil refineries more efficient. Although technically still working towards energy efficiency, these projects are not helping the environment to the extent that issuers will often claim.
This issue, realistically, is inherent within any method of raising money to be used for a good cause. An illustrative example would be the donations people make to charities. There have been numerous instances in which international aid funded by domestic donations to charity goes directly to the elites in developing countries, while those in need remain disadvantaged. Although the donors still get the mental ease of believing that they helped solve a problem, their money is actually used to fund state-sponsored companies run by these wealthy individuals. Therefore, individuals already at the higher levels of society are able to leverage their wealth to continue making money, while those most in need continue to suffer. These misguided donations traditionally solve either the wrong problem, or no problem at all.
Given this history with donations and Green Bonds, large financial institutions are wary of classifying every green bond under the same umbrella. Instead, climate agencies and proponents of green bond programs are taking steps to classify the levels of impact that a green bond may have to help inform potential investors. Key examples of this are the Green Bond Principles that were approved by the International Capital Market Association in 2014, the Cicero Shades of Green program, and the European Union’s Green Bond Standard. All of these programs are steps in the right direction for standardizing Green Bonds and are resulting in more focused investments that are creating substantial impact. Like with many other forms of impact investments, creating clear metrics for quantifying the impact achieved is crucial in validating the idea of impact investing for traditional investors. The same holds true for Green Bonds. For them to fully find a place in the securities portfolios of investors worldwide, accurately classifying the projects they will be used for, and the expected impact from them, will be necessary.
Already, the impact from more organized and accurately described Green Bonds is being realized in domestic and international markets. In Mexico and Peru, 24,400 rural households are being powered by solar voltaic systems financed by World Bank Green Bonds. In the Dominican Republic, Tunisia, and Indonesia, 442,650 hectares of land were given new, rehabilitated or restored irrigation services through the same mechanism. Following guidelines set by independent organizations is proving to be effective in directing funds in a more impactful manner.
If Green Bond descriptions and uses can be internationally standardized, there are vast benefits that may be realized from their implementation. For the issuers of the bonds, Green Bonds provide influxes of cash for projects that may traditionally receive lower investments because of their lower profit margins. Moreover, pioneering sustainability projects is a key marketing tool for companies and will allow them to attract more media attention. Implementing Green Bonds will help shine a light on sustainable initiatives and, hopefully, bring them mainstream even more. For investors, standardized Green Bonds will lead to a more nuanced ability to invest in values over profits. Green Bonds will be essential for impact investing as they provide the unique ability for an investor to support a specific cause and, thereafter, find a specific project working to better that cause. For that reason, monitoring the development and formalization of the Green Bond market will be a key action item for any sustainable economist.